The Holy Grail Economic Policy Guaranteeing Maximum Sustained Economic Growth, Low Unemployment, and Low Inflation, Avoiding Booms and Busts

Using its standard monetary policy, the Federal Reserve has been struggling to get inflation stably up to its stated target of 2%, believing that level corresponds to sustainable economic growth. The problem is that monetary policy not only acts with unpredictable time lags, it is also imprecise as a tool. Furthermore, it often has negative side effects, such as stifling investment when monetary policy is too restrictive, and creating financial and/or real estate bubbles when it is too loose. Careful analysis leads to one conclusion: the solution for an optimal economic policy is to give primacy to fiscal policy, using monetary policy as an adjunct. Specifically, using QE-financed tax rebates as the standard economic stimulus tool, and temporary tax surcharges as the standard tool for avoiding excess aggregate demand and subsequent demand-pull inflation. This optimal economic policy requires coordination between Congress, the Federal Reserve, and the president.

It makes no sense to choose a system whereby one takes indirect measures with imprecise and delayed outcomes combined with negative side effects, instead of choosing a system whereby one takes direct measures with precise and immediate outcomes combined with no negative side effects. Astonishingly, while a direct system could have been chosen, our economic policy system has long been predominantly an indirect one, and that explains the repeated long recessions with high unemployment and the sub-potential growth the nation has endured over the past fifty years. Finally, some economists, including at the Federal Reserve, are starting to ask whether our economic policy system should be changed.

It must be understood that there are times when raising or lowering interest rates has little relevance to the economic situation and is therefore ineffective or even counterproductive. Two examples follow. First, the expression “pushing on a string” reflects the inability of low interest rates to always stimulate an economy. We witnessed this situation in the aftermath of the 2008–9 financial crisis and recession, when lower interest rates were incapable of rapidly stimulating economic growth (through increased borrowing and spending) due to the over-indebtedness of consumers, the excess capacity of businesses, and the precarious balance sheets of many banks. The proper economic policy response would have been not extremely low interest rates (which, by the way, are very unfair to savers and counterproductive by reducing interest income, an important component of personal income) but an immediate large tax rebate financed by the Federal Reserve through QE, putting money in consumers’ pockets in order to stimulate spending and to help families in financial difficulty keep current on their mortgages. Both the recession and the banking crisis would have been nipped in the bud had the 2009 $800 billion Obama stimulus consisted entirely of a tax rebate. How is that? $800 billion was the equivalent of a $5,000 tax rebate. A family of two taxpayers would have received two checks for a total of $10,000, plenty to avoid most mortgage defaults. The recession would have ended instantly and TARP would not have been needed. The Obama plan instead provided financial assistance to people who didn’t need it (v. new home buyers, new car buyers (v. “cash for clunkers”), and state and local governments). Consequently, it did nothing to quickly end the recession and the banking crisis.

Second, the expression “stagflation” (minted during the energy crisis 1970’s) reflected the rare and seemingly contradictory simultaneous occurrence of recession and inflation, which put monetary policy in a quandary. By not making the distinction between “cost-push” and “demand-pull” inflation, the Federal Reserve mistakenly opted for extreme monetary tightness and sky-high interest rates to deal with the high inflation of the 1970’s and early 1980’s which was caused by exploding energy costs, not by excess aggregate demand. The high interest rates deepened the recession while doing little to reduce inflation (since it was not due to excessive aggregate demand), and prolonged the energy crisis by raising the investment threshold for investments in new energy production and conservation. The proper economic policy response to the energy stagflation phenomenon would have been to keep the fed funds rate equal to -not far above!- the current inflation rate (essentially a neutral monetary policy stance) so as to not discourage investments in energy conservation and production, and to have a big tax rebate to prop up consumer demand which was plummeting.

Both the above examples highlight one essential truth: fiscal policy is much more adept at managing the economy than traditional monetary policy focusing on increasing or lowering interest rates. So what would be the optimal economic policy? It would consist of 1) having monetary policy always neutral and on automatic pilot, with the fed funds rate targeted monthly by the Federal Reserve at the current inflation rate (the trailing 6-month CPI rate); 2) of having QE-financed tax rebates (instead of sharply lower or ultra-low interest rates) as the standard economic stimulus tool; and 3) having temporary income tax surcharges (instead of sharply higher interest rates) as the standard tool for preventing excess aggregate demand inflation. (It is not difficult for the Fed to calculate how much tax relief or tax increase is needed at any given point in time to prevent recession/unemployment or “demand-pull” inflation from developing. All it needs to do is check the unemployment and capacity utilization rates to gauge the amount of slack. As for “cost-push” inflation, the Fed does not have to be concerned with it since market forces eliminate it in due time, as proven by what has happened with oil prices since 1973.) How to implement this optimal economic policy politically? Very simply, any time the Fed thinks tax rebates or tax surcharges are necessary, it would ask for a meeting with the president and congressional leaders and their approval. As a timesaving measure, Congress could pass a law requiring immediate automatic approval subject to congressional and presidential review.

The merit of QE-financed tax rebates as the standard stimulus tool, apart from their instant effectiveness, is that they are fair since each and every taxpayer receives the exact same stimulus check from the U.S. Treasury. There is no discrimination as there is with “targeted stimulus” which benefits only certain categories of taxpayers. Consequently, QE tax rebates will never face complaints from taxpayers and rarely face political obstacles. Especially if everyone understands that since QE financing of Treasury bonds consists of printed money, those bonds (when held to maturity by the Fed) are not “real” debt, only “virtual” debt which evaporates in thin air at maturity. Therefore, they pose no burden on either current or future generations of taxpayers.

With a proper understanding of public debt financed by QE, we would not have underinvested for fifty years in critically important infrastructure (including education), even in military expenditures necessary for an optimal national defense. We would not have hesitated to provide enough stimulus in order to prevent long recessions and high unemployment. Not having such understanding, we have greatly underperformed economically and socially. At the same time, we have actually greatly increased public and private indebtedness through repeated deep recessions and high unemployment, through periods of excessively high interest rates, and through a nonsensical growth policy based on stimulating borrowing and increased indebtedness. The critical question is, how long will it take to finally have an enlightened economic policy?

© Edward Sonnino 2019

May 17, 2019